Earn-Out Explained

When you sell your healthcare company, part of the price will be based on your company’s expected future performance. This is often something buyers and sellers disagree on. A seller typically has more optimistic forecasts while a buyer might be more cautious to negotiate a lower price. As a result, it can be hard to agree on a valuation because so much of this is based on the future.  If you’re confident about the future performance of your company, you could compromise by structuring part of your deal with an earn-out. This is a type of financing agreement that could leave you with a larger payout than a straight sale, assuming the business performs well post-acquisition.

How do earn-outs work?

When you use an earn-out, part of your proceeds will be based on the future performance of your company. For example, you could receive 90% in cash and then the other 10% would be from the earn-out. You would structure the earn-out based on your company’s performance goals like earnings, profits, patient retention, etc. over the next few years. Most earn-outs use a schedule of 1 to 3 years. The amount you would receive in payment is based on the negotiated benchmarks. If your company meets expectations or exceeds them, you’ll receive more money. If the company doesn’t meet the targets, the amount you’ll receive will be less.

While not always, earn-outs typically require that you stay involved with running the business after the sale. You’d want to be there to make sure your company performs as well as possible so you can maximize your earnings.

Keys to successful earn-outs

Before setting up an earn-out, you need to have realistic expectations about your company’s future performance. If you’re too optimistic, you could end up setting targets that will be impossible to meet. You should have an M&A professional or CPA firm analyze your company’s performance so you can base your benchmarks on their unbiased forecasts.

Earn-outs should be based on simple, straightforward performance metrics. Try to keep the agreement to one or two metrics that are very easy to define and track, like revenue or patient census growth. If you build an earn-out with a large number of factors, it will be more difficult to monitor the appropriate metrics. It could also lead to disagreements because you interpret the metrics differently than the buyer.  Earn-outs should also list exceptions to the performance targets for problems that are not under your control. For example, if the buyer makes hiring or capital investment decisions that impact the metrics related to your earn-out.

You should limit you’re the earn-out to only a few years going forward. Certainly keep the earn-out under 5 years. Otherwise, as time goes on, the business’ performance will be less related to the company you sold. If your earn-out goes for too long, problems could come up that were not under your control but would still limit the amount your amount you earn.

Considerations before making an earn-out

Before deciding on an earn-out, you need to decide whether you actually want to stay involved with running the company post-transaction. If you’d like to get out of the business as soon as you sell, earn-outs are probably not ideal.  In cases where the seller is leaving soon after the close, earn-outs should be limited to 24 months or less.

You also should consider how well you get along with the potential buyers and whether you could see yourself working with them. If there is tension, it could lead to trouble during the earn-out, especially if you start missing performance targets. Finally, you should consider why the buyer wants to do an earn-out in the first place. If it’s their only option because they have no cash, they may struggle to grow the business if access to cash is limited.

Earn-outs can lead to a more lucrative sale but only if they are handled properly. By considering these factors, you can decide whether an earn-out is appropriate and additive to the success of the transaction.